USA Inbound Acquisitions & Investments Blog : Inbound Investment Lawyer & Attorney : Sullivan & Worcester Law Firm : Mergers & Acquisitions, Cross Border Investments

Foreign direct investment (FDI) in a formidable natural gas deposit located under the northeastern United States is occurring at a breath-taking – perhaps even breakneck – pace this year. There is no indication that the U.S. government has reviewed any of these transactions for national security considerations. If it has not, then that is a plus, as review would hinder the accumulation of needed capital. This is a case where the government aids U.S. national security by abstaining from exercise of authority. 

To date in 2010, foreign investments in the Marcellus Shale formation have included transactions between U.S. companies and Japan’s Mitsui & Co., Norway’s Statoil, Britain’s BG Group, and Chinese and Korean sovereign wealth funds, to name a few. If the shale gas that lies below New York, Pennsylvania and West Virginia can be safely extracted at a competitive price, in terms of both economic and environmental costs, the United States may be able to radically decrease its reliance on imported oil. Funding the development costs and building the extraction technology are the primary challenges. Meeting these challenges requires significant investment capital. 

That’s where foreign partners come in. Just as U.S. entrepreneurs were willing to seek significant amounts of foreign investment capital for the building of U.S. railroads in the nineteenth century, their exploration and production descendents have wisely decided to partner with worldwide sources of investment capital. And the current low price environment for natural gas makes these deals attractively priced for foreign investors. Throw in the ability to learn (or even copy) the hydraulic fracturing technology used to access the shale gas, and the investment almost sells itself. 

Although the U.S. government has the authority to regulate, it has wisely chosen not to do so. Marcellus transactions are closing at a record pace, allowing U.S. owners to accumulate the dry powder they need to convert the prospect of energy independence into the real thing. 

Take for example one of the 2010 Marcellus transactions. Mumbai-based Reliance Industries acquired a 40% interest in Pennsylvania-based Atlas Energy Resources. Did the parties file with the Committee on Foreign Investment in the United States (CFIUS)? Their press releases don’t mention a filing. The purchase agreement did not reference any requirement that either party make the voluntary filing with CFIUS. CFIUS clearance was not a condition to closing. The deal was signed on April 9 and was closed on April 21, 2010.   CFIUS review generally takes at least 30 days. The time frame suggests no review and no filing. 

In another deal—the investment by the UK’s BG Group plc in EXCO Resources—the investment agreement references antitrust review but not foreign investment clearance. Purchase agreements for the other 2010 Marcellus Shale deals are not publicly available. It is difficult to assess whether the parties subjected their deals to voluntary CFIUS scrutiny to avoid a regulatory challenge to the transactions after their completion. 

Why is there any doubt about CFIUS review? CFIUS screens FDI transactions to identify U.S. national security risks. The official guidance it published in December 2008 states that U.S. requirements for energy sources is a factor it considers. Effects on critical technologies is another. Effects on physical critical infrastructure “such as major energy assets” is a third. CFIUS has given fair warning that those investors who come to the U.S. to invest in U.S. major energy assets fall within its purview. 

It is therefore not surprising that foreign buyers of U.S. oil and gas interests have invoked CFIUS review. The 2009 Annual Report of CFIUS (unclassified edition) specifies that four of the 404 notices filed with CFIUS in 2006-2008 were for oil and gas extractive industry transactions. The annual report does not identify the transactions. Whether any of them involved Marcellus Shale is simply not known.

CFIUS does not announce its decisions on specific deals. There nonetheless is precedent. At the end of 2009 CFIUS blocked a proposed Chinese investment in a failing U.S. gold miner, FirstGold. Whatever the basis for the regulatory position, FirstGold made clear that CFIUS can wield its authority in extractive industry deals.

CFIUS may have it just right this time. U.S. national security requires that not only the U.S., but also the world at large, develops as many safe alternatives to oil in as many locations as possible. According to a recent special report in The Wall Street Journal, shale gas discoveries in the U.S. and elsewhere will prevent energy cartels from forming and deprive the petro-states of their influence in world affairs. Financial Times columnist Gideon Rachman argues that national security of the U.S. and other countries as well requires development of shale gas wells and that accordingly any investment – domestic or otherwise – that develops these resources should be encouraged. 

It’s a safe bet that the regulators are aware of these views as well. Seeming inaction may be saying more than any articulated policy could. There is more than one way to announce, “Open for business.” 

Or, contrary to our view, does the U.S. need to be more protective here? Is there a case to be made for screening to insure that we are not allowing other nations to strip our prized assets? If you believe there is, your comment is welcome. 

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The regulatory clearance process for inbound acquisitions is playing a central role in the ongoing takeover contest for Terra Industries, Inc. A second buyer has made a higher bid and has cited Terra’s need for regulatory approvals and regulatory delays in the agreed-upon deal in arguing its case to Terra’s shareholders. That and other factors now seems to have won the day for the second buyer. 

Terra is based in Sioux City, Iowa and produces and markets nitrogen and methanol products, predominantly agricultural fertilizers. In February, Norway’s Yara Iternational ASA, the world’s largest fertilizer company, agreed to pay $4.1 billion to acquire Terra in a merger transaction. The merger requires the approval of the stockholder of both companies. According to the Alfidi Capital blog, Yara’s bid for Terra was valued at $41.10 per share. The parties have agreed that the transaction is expressly subject to review by the Committee on Foreign Investment in the United States (CFIUS).

Terra’s merger agreement, as filed with the SEC, illustrates the operation of the U.S. statutes and regulations that apply to an inbound investment. First, the U.S. business that is the target warrants to the buyer – Yara in this case – that the approval of CFIUS is among those governmental consents that are required for the transaction to be completed legally. Second, the U.S. target and the foreign buyer then agree to cooperate to make the necessary filings with CFIUS and to update those filings as necessary. Third, as a condition to completion of the transaction, full regulatory compliance must have been achieved. For a more complete analysis of these and other contractual provisions that are used in acquisitions, please visit the Sullivan & Worcester Web site and review our white paper that discusses contractual provisions.

On March 2, CF Holdings Industries, Inc. of Deerfield, Illinois announced that it was offering $47.40 per share for Terra, or $620 million higher than Yara’s bid. Earlier this year, CF had ended its year-long attempt to acquire Terra. CF’s new bid is $840 million higher than its last bid. Because CF Industries, Inc. is not a foreign buyer, review by CFIUS is not a factor. In its press release, CF says that its offer not only has higher value than Yara’s but is not burdened with the various conditions that apply to Yara’s offer. CF’s letter to Terra’s directors cites “numerous conditions beyond Terra’s control [that] will not be satisfied, including regulatory, legislation and stockholder approvals.” Obviously, CFIUS approval falls under the first of these categories. The Daily Finance blog also handicaps the Yara offer because of CFIUS screening. CF gives Terra the opportunity to make a quick deal.

Going back to the Yara deal, it may be interesting to speculate what factors in its business drove the decision to file with CFIUS. Submitting a notice to CFIUS is optional. If there is no filing and CFIUS later determines that the acquisition adversely affected U.S. national security, CFIUS can attempt to unwind the transaction. The mere prospect that an unwinding might subsequently occur is sufficient to lead parties, their advisors and their financing sources to play the game conservatively and engage in the CFIUS screening process.

Viewed from a less conservative perspective, however, perhaps Terra’s transaction does not affect U.S. national security. Terra’s last annual report did not disclose that it had contracts with the U.S. government or that it was satisfying U.S. defense requirements. Additionally, Norway is a NATO ally and is not a proliferation risk. It is more likely that Terra’s fertilizer products are considered critical resources and material in U.S. agricultural markets. Interestingly, among the risk factors in its annual report is Terra’s disclosure that its fertilizers can be used as explosives and that “governments could impose limitations in the sale, use or distribution of [its products],” so there may well be a general security consideration in the background. On balance, the more conservative position with respect to CFIUS seems warranted.

CF appears to have gained the initiative with its heftier price and its arguments that rely on conditions that apply only to Yara’s deal. Today, Terra announced that its board had notified Yara that CF’s offer constituted a superior offer and that, barring an overbid from Yara within 5 days, Terra would terminate its merger agreement with Yara. Although not the only factor by any means, CFIUS review is tilting the contest toward the domestic buyer. 

We are forced to ask whether that was among the intended results of the legislation that regulates foreign direct investment. 

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Late last week reports surfaced that the China National Offshore Oil Corporation (Cnooc), China’s state-owned energy company, was in unconfirmed discussions with Norway’s StatoilHydro ASA to acquire oil lease interests in the Gulf of Mexico. A completed transaction would open up oil reserves in the U.S. Gulf to China for the first time. The fact that a Chinese company is involved has led to speculation whether the U.S. will resist this particular foreign direct investment, recalling the political furor that resulted in Cnooc’s unsuccessful 2005 bid to acquire Unocal Corp. 

Environmental Capital blog linked to a Wall Street Journal’s report that StatoilHydro had put five prospects up for sale, a small portion of its Gulf of Mexico assets. The Financial Times wrote that the transaction would have a value of approximately $100 million and that the proceeds would be used to cover the costs of drilling wells rather than to obtain acreage. According to Energy-pedia, StatoilHydro will remain majority owner of any projects for which it brings in partners, noting that oil companies typically offer partnerships in large exploration projects to help pay for drilling and spread risk. 

Generating alarmism, Business Insider first claims that China’s overseas acquisition program is approaching the U.S. and then becomes somewhat more balanced: 

[T]he political tides have changed. In 2005, it was easy to block investments on political grounds, because there was no shortage of cash. Plus, this is just a few leases -- putting their toe in the water, it looks like -- not an $18.5 billion bid for a U.S. company.

Still expect all kinds of howls before this goes through.

Assume that the media has accurately outlined the transaction. Will the transaction between StatoilHydro and Cnooc be a “covered transaction” under the Foreign Investment and National Security Act of 2007 (FINSA)? If so, will the parties then make a voluntary filing with the Committee on Foreign Investment in the United States (CFIUS)?

Not every transaction involving a non-U.S. investor and a U.S. business is subject to FINSA. Only a transaction that “could result in control of a U.S. business by a foreign person” is. A transaction that satisfies this transfer of control test is a “covered transaction.” But not every “covered transaction” is subject to FINSA. The general structure of FINSA is that parties to a covered transaction may file a notice with CFIUS for its review and, possibly, further investigation or Presidential action. If the parties do not file a notice, then CFIUS can block the transaction or later unwind it. The purpose of the CFIUS review and investigation is to determine whether the proposed transaction might impair U.S. national security. 

CFIUS has published regulations that detail the coverage of FINSA, the review process and the contents of the voluntary filing. Applying the facts of the Cnooc discussions to the regulations produces some interesting results:

Does the fact that a Norwegian entity owns the oil leases save the deal from regulatory review? No. A U.S. business is subject to the regulations and to FINSA regardless of the nationality of the person that controls it.^[1]

Are the oil leases a U.S. business? To be a U.S. business, the leases must be an entity engaged in interstate commerce in the United States.^[2] Are they? The regulations define “entity” to include “assets (whether or not organized as a separate legal entity) operated by any [other entity] as a business undertaking in a particular location or for particular products or services.”^[3] Therefore, the leases could be an “entity.”

If the leases are an entity, is the entity engaged in interstate commerce in the United States? The wells are offshore, and not located within the boundaries of any state of the United States, as can be seen from the map published by Energy-pedia. The media coverage says that the leases are located in the “U.S. Gulf.” Is that a state or is it not?

Also, since the wells appear to not yet be operating, are the assets engaged in any commerce at all?

Under the regulations, certain transactions are not covered transactions, including the “acquisition of any part of an entity or of assets, if such part of an entity or assets do not constitute a U.S. business.”^[4] There is an example in the regulation of a foreign person acquiring individual discrete assets -- including land -- from a U.S. business. The example concludes that the acquisition is not a covered transaction. 

If its purpose is to finance drilling, rather than to obtain acreage, then the proposed transaction is an investment, not an acquisition. FINSA, however, applies to investments if control is tranferred. The structure of the deal may be that Cnooc will obtain lease interests. If these interests do not have rights to vote for directors or vote on other matters affecting the entity, then the interests are not voting interests and there may be no “control” aspect to the transaction at all.^[5]

Lastly, if Cnooc is acquiring interests from StatoilHydro without any intent to exercise control, then Cnooc may be acquiring the interests or the leases “solely for the purpose of passive investment,” and the investment may be exempt from FINSA on that basis.^[6] The observation that StatoilHydro intends to remain in operating control supports this view. 

Overall, there could be several bases for the legal conclusion that the proposed deal would not be a covered transaction under FINSA. Cnooc and StatoilHydro will no doubt take their own business assessment of their situation. It will be interesting to see if the views coalesce or diverge. 

All references are to Sections of the CFIUS regulations: 

^[1] Section 226

^[2] Section 226

^[3] Section 211

^[4] Section 302(c)

^[5] Section 228

^[6] Section 302(b)

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We wanted to alert you to a recent development that may be of interest to the FDI community. On July 1, 2009, the Civilian Agency Acquisition Council and the Defense Acquisition Regulations Council issued an interim rule prohibiting the award of U.S. government contracts using appropriated funds to any foreign incorporated entity that is treated as an inverted domestic corporation or to any subsidiary of one. The rule implements Section 743 of Division D of the Omnibus Appropriations Act, 2009 (Public Law No. 111-8). The Department of Homeland Security (“DHS”) has had a similar rule since December 2003, but the new interim rule applies to all federal agencies.

Briefly put, an inverted domestic corporation is one that (1) used to be incorporated in the United States or used to be a partnership in the United States but now (2) is incorporated in a foreign country or is a subsidiary whose parent corporation is incorporated in a foreign country. Congress enacted Section 743 – as well as an earlier tax statute – to discourage would-be corporate expatriates from trying to avoid United States taxes on business income generated in foreign countries by incorporating in “tax havens” such as Bermuda, Barbados and the Cayman Islands.

Section 743 borrows the definition of “inverted domestic corporation” from the DHS statute, which in turn is related to the tax statute. The long three-part definition defines an “inverted domestic corporation” as a foreign incorporated entity that, pursuant to a plan (or a series of related transactions):

1. Directly or indirectly acquires substantially all of the properties held directly or indirectly by a domestic corporation or substantially all of the properties constituting a trade or business of a domestic partnership
2. Acquires at least 80 percent of the stock (by vote or value) of the entity held (a) in the case of an acquisition with respect to a domestic corporation, by former shareholders of the domestic corporation by reason of holding stock in the domestic corporation, or (b) in the case of an acquisition with respect to a domestic partnership, by former partners of the domestic partnership by reason of holding a capital or profits interest in the domestic partnership, and
3. After the acquisition, the expanded affiliated group that includes the entity does not have substantial business activities in the foreign country in which or under the law of which the entity is created or organized when compared to the total business activities of such expanded affiliated group.

Under the regulatory scheme, an offeror for a U.S. government contract must represent that it is not an inverted domestic corporation or a subsidiary of an inverted domestic corporation. If the offeror cannot affirmatively make such a representation, then the offeror cannot submit an offer absent a secretarial-level waiver that contracting with the inverted domestic corporation or its subsidiary is in the interest of national security.

Because of the complexity of the definition of “inverted domestic corporation,” companies that could be considered inverted domestic corporations should consult legal counsel.
 

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Developments in corporate restructurings suggest that the Foreign Investment and National Security Act of 2007 (FINSA) may soon become a factor in debt/equity swaps. As U.S. companies in the telecommunications, defense and other national security-related businesses encounter difficulty in refinancing their debt and seek out-of-court workouts with foreign bank lenders or offshore hedge funds, FINSA’s regulations may apply and could impede those settlements.

The Wall Street Journal reported on September 19 that as a result of the credit crisis, lenders are taking sizable equity stakes of companies that borrowed from them and now must restructure their debt. These lenders are confronting the issues raised by Federal limits on ownership of media businesses in conjunction with equity-for-debt swaps transacted with radio, TV and newspaper companies in distress. The FCC rules have made restructurings more complex. The FCC must approve changes in ownership for a broad range of media businesses. FCC rules limit ownership of multiple media outlets in different markets and apply to all persons, regardless of nationality. But for foreign hedge funds and other foreign lenders, there is an additional set of issues. Federal law also fixes caps on equity ownership of broadcasters by foreign entities. The application of these rules has made restructuring far more difficult to achieve because it limits the amount of equity that can be swapped for debt.

There is a parallel to FINSA and its rules. FINSA applies to transactions between U.S. businesses and foreign entities that acquire control of the U.S. entity. In that case, the parties may file a voluntary notice with the Committee on Foreign Investment in the United States (CFIUS). To determine whether U.S. national security might be impaired as a result of the change in control of the U.S. business, the filing leads to a review process and, in some cases, an investigation and, even more remotely, Presidential review. If CFIUS does not object to the transaction or require that the parties enter into a mitigation agreement with it, then the transaction can proceed and further review is precluded. If the parties do not file a notice and comply with requests for information from CFIUS, then CFIUS can later unilaterally review and investigate the transaction and, in an admittedly extreme case, order divestment. 

Where might these issues arise? The fact pattern would involve:

• A U.S.-based company operating in an industry which is relevant to U.S. national security -- examples include, mineral extraction, energy, defense, telecommunications and certain manufacturers of highly engineered products
• A foreign lender -- traditional or otherwise, including hedge funds -- that now finds that it has little choice other than to take an equity stake
• The equity stake issued in exchange for the debt exceeds 10% of the voting equity of the business on an after-issued basis or has other rights, such as board membership, that give the lender a role in the management or operation of the business

The presence of other factors would exacerbate CFIUS concerns:

• One or more of the lenders is controlled by a foreign government -- as a result of the financial turmoil of the last several years, these categories include all of those bank lenders which, although formerly private, have since been nationalized
• The foreign lenders or offshore funds taking the equity enter into agreements with each other for the operation or management of the U.S. business

Under the FINSA statute, CFIUS has an unlimited period of time to look back and order reviews of previously completed transactions. Therefore, if an offshore lender’s strategy is to restructure today with a debt-for-equity swap and then sell the equity to a buyer -- U.S.-based or foreign -- in a year or two, a background legal issue may appear: Do the sellers have full, indefeasible legal title to the shares they are seeking to sell? Will their buyer in turn become sensitive to the possibility -- however remote -- that a CFIUS investigation may materialize in the future if a competitor brings the absence of a filed notice to the attention of CFIUS? Or if a voter brings the issue to the attention of a Congressperson who in turn will pressure CFIUS?

This chain of events may be far-fetched. But the provisions of FINSA and its regulations make this outcome possible, whether or not likely. Foreign lenders and their advisors may well have no choice but to consider the applicability of these requirements.

L. Elise Dieterich, a partner in the Washington, D.C. office of Sullivan & Worcester LLP, contributed to this post.

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A comment to this blog received last month questioned whether regulatory screening of inbound mergers and acquisitions by the United States conflicts with U.S. bilateral investment treaties (BITs).

BITs generally promise that the host country will treat all inbound investors equally with investors from the host country. The rationale is clear -- based on the treaty provisions FDI will flow into the host country and will be protected. BITs promise investors fair and equitable treatment for their investments, equal treatment with the host’s own nationals and “most favored nation” treatment, as well as a guarantee of full compensation should appropriation occur. BITs also establish an agreed-on tribunal for resolving disputes under the treaty.

The objective of BITs is to generate FDI. The general model of BIT currently used by the U.S. extends equal treatment with U.S. investors not only to businesses once established but also to the period prior to the actual creation of the investment, that is, while there is an agreement to acquire or invest. On the other hand, the purpose of a regulatory screening regime, such as the Committee on Foreign Investment in the United States (CFIUS), is to filter inbound mergers and investments so that foreign ownership does not impair the ability of the U.S. to defend itself. The policy is rooted in national security, not economic security or the protection of U.S.-based businesses against external competition. CFIUS implements its policy during the pre-investment phase.

The resolution to this apparent conflict between policies and the answer to our commenter’s question is found in the BIT itself. The current U.S. model form has the following provision, entitled “Essential Security,” that describes certain “Non-Precluded Measures” that the treaty permits the U.S. or the other treaty party to take:

Nothing in this Treaty shall be construed . . . to preclude a Party from applying measures that it considers necessary for the fulfillment of its obligations with respect to the maintenance or restoration of international peace or security, or the protection of its own essential security interests.

In laymen’s terms, as long as the CFIUS review is undertaken to protect essential security interests, it trumps the BIT’s provisions.

A few interesting facts about BITs, all extracted from a comprehensive and detailed overview of the topic authored by Lisa E. Sachs and Karl P. Sauvant of the Vale Columbia Center on Sustainable International Investment:

• the number of BITs worldwide have literally exploded over the past half century from one in 1959 to 2,573 in 2006, with more than 2,000 of these having been signed since 1989
• by the end of 2006, 177 countries had entered into one or more BITs
•  the economies with the most BITs are Germany (135), China (119) and Switzerland (114)
• the U.S. is not listed among the 10 countries who are parties to the greatest number of BITs, although it is the country that has entered into the greatest number (148) of double taxation treaties

The Sachs/Sauvant overview is essential and interesting reading for anyone seeking an informed perspective on the interplay BITs and FDI.

Thanks to my partner Jim Silkenat for his assistance in preparing this post.

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The Foreign Investment and National Security Act of 2007 (FINSA) and its regulations are intended to strike a balance between the opportunities and threats associated with inbound investment into the United States. The regulatory structure for addressing the conflicts often created by inbound investments is review by the Committee on Foreign Investment in the United States (CFIUS), and its approval or disapproval of acquisitions and investments that might harm genuine U.S. interests.

For example, if a foreign nation with intent inimical to the United States were to acquire a high-tech business whose products were, or had the potential to be, essential for the critical functioning of large portions of the U.S. economy, the regulators would scrutinize the risks arising from the transaction. If necessary, the regulators would impose conditions to mitigate those risks or perhaps even block the transaction. Because it is based on national security grounds rather than economic security grounds, the system is designed to be less susceptible to undue political influence. 

A reasonably designed system would also designate a class of transactions between a foreign buyer and a U.S. target that need not be scrutinized. One reason for doing so would be that certain transactions as a class present low risks to U.S. national security. Therefore the costs of review far outweigh possible benefits. Similarly, the efficient and timely functioning of the regulator may require that fewer than all transactions be reviewed. In defining the class of transactions that is except from the system, legislators often use quantitative, rather than principle-based, measures. So, for example, review by CFIUS does not reach investments of less than 10% of outstanding voting stock of a U.S. business if the investment is passively held. The exemptive rule applies both to an initial investment in a U.S. business and to subsequent transfers that the investor may make to foreign persons. The rule applies to transfers made by the transferee and by any subsequent transferee as well.

The exemption, however reasonable, can lead to questionable results. For example, after a recent transaction Aabar Investment PJSC of Abu Dhabi has now come to own approximately 4% of Tesla Motors Inc. of San Carlos, California. Tesla is perhaps the most advanced developer of commercial all-electric cars in the United States. Aabar is an investment company whose largest stakeholder is the International Petroleum Investment Company, which in turn is wholly-owned by the Government of the Emirate of Abu Dhabi. Aabar’s shares also trade on the Abu Dhabu Securities Exchange. Aabar acquired its interest in Tesla from Daimler, AG, based in Stuttgart, Germany. Daimler had acquired an interest of slightly less than 10% in March of this year in exchange for an infusion of $50 million into Tesla. Aabar holds 9.1% of Daimler, making it Daimler’s largest shareholder. According to the blog earth2tech, Daimler never intended to keep the full investment for long. Daimler and Tesla apparently tried to make the original investment jointly, but terms could not be fully worked out between them in March.

There is no indication that either Daimler’s original investment or its resale to Aabar underwent CFIUS scrutiny, even though Aabar is a government-controlled entity. Both seem to have relied on the exemption for acquisitions of less than 10% of shares. 

Now to engage in a law school-styled hypothetical. What if the participants were other than Daimler or Aabar? Suppose the shares wound up in the hands of a nefarious investor who intended to use its position to retard Tesla’s technology or to put it in the hands of an ill-willed competitor. As noted above, reasonable standards for exemption may be necessary to prevent bureaucratic overreach. Reasonable standards can, however, morph into a pathway for circumvention. 

Tesla has presumably protected its own interests. It may have retained the ability to approve or limit transfers and subsequent transfers of its shares. It may have restricted by contract its obligation to share its technology with stockholders. It may have imposed legal limitations on the ability for any investor who has access to its technology to use or transfer it. These protections are normal and sound, as long that the company has the bargaining power to obtain them while negotiating the deal with its prospective investors.

As a final note, there must be something about the name Tesla that attracts the possibility of bad acts. Nikola Tesla was a Serb-American physicist and electrical engineer, inventor of the radio and the electric motor and generator. He is regarded as one of the major forces in the development of commercial electricity. Although famous in his day, Tesla became embroiled in disputes with Marconi others about his intellectual property. No doubt the responsible executives at Tesla Motors are aware of the burden of history.   

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A Primer for the U.S. Business on the Required Information for the CFIUS Filing

A previous post described what the foreign party needs to disclose in its filing to the Committee on Foreign Investment in the United States, or CFIUS, when it wants to merge with, acquire or otherwise take over a U.S. business. Today’s post summarizes the information required from the U.S. business.

From the perspective of the U.S. business, the filing should provide a thorough presentation of those aspects of its business and operation that could raise what CFIUS deems to be national security considerations. In the case of the acquisition of some, but not all, of the assets of an entity, the U.S. business is to provide the requested information only with respect to those of its assets that have been or are proposed to be acquired. In all events, the notice that the U.S. business files should cover six general areas:

1.         What’s your business? The U.S. business must describe its business activities, including:

•  product and service categories;
• market share estimates;
• a list of direct competitors; and
• the address of facilities manufacturing certain products or services. 

2.         Really, what’s your business? The U.S. business must further respond to detailed questions regarding its business operations and critical technologies (as defined by FINSA) that it owns or licenses. If the U.S. business responds affirmatively to any of those questions, it also must provide additional disclosures. The questions include whether the U.S. business:

• supplies products or services to the U.S. government and whether it is the single qualified source for those products or services;
• manufactures or provides services for other parties that it knows are rebranded by the purchaser or incorporated into the products of another entity;
• produces products or provides services subject to various defense-related statutes or regulations;
• holds other licenses, permits or authorizations from the U.S. government; and
• has any technology with military applications.

3.         Have You Any Government Contracts? The U.S. business must state whether it:

• is or has been a party to contracts with the U.S. government involving classified information or technology or with agencies with responsibility for national defense, homeland security or other aspects of national security; and
• is or has been a party to any priority-rated contracts or orders under the Defense Priorities and Allocations System (DPAS regulations).

These questions require information going back three years in some cases and five years in others.

4.         What’s the CyberPlan? CFIUS requires that the U.S. business indicate whether it has a cyber-security plan. If so, it must attach a copy of the plan.

5.         Attach your Reports. The U.S. business must attach its most recent annual report. If the financial results of the U.S. business that is the target are consolidated with the results of its parent, the report of the parent may, in some cases, be sufficient. If the U.S. business does not prepare an annual report and its results are not included elsewhere, the filing need only include the business’s most recent audited financial statements. If there is none, then the business must attach its most recent unaudited financial statements.

6.         Jointly Presented Information. The CFIUS regulations require that, except for a hostile takeover, the U.S. business and all other parties to the covered transaction must disclose certain information, which is best accomplished when all parties file one notice. The information includes:

• general identifying information about the parties, and their parent entities;
• a description of the transaction in sufficient degree to permit CFIUS to determine whether the transaction’s structure brings it within the definition of “transaction” for purposes of its regulations;
• the anticipated completion date;
• the approximate value of the transaction;
• the identities of all financial advisors, underwriters and financing sources for the transaction; and
• the history of prior dealings between the parties and CFIUS, including whether any party is or has been a party to a prior mitigation agreement with CFIUS.

Of course, the descriptions of the six items above are summaries only. Reference should be made to the CFIUS regulations for the complete and definitive requirements. The assistance of a competent legal advisor in responding to these requirements is recommended.

More complete information about the filing can be found in our white paper, “Complying with the Voluntary Review Process When Investing in or Acquiring a U.S. Business.”

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Inbound investments into the United States by sovereign wealth funds (SWF’s) were the subject of a second report issued last month by the Government Accountability Office (GAO). Last September GAO released a report describing data that was available on the size and investments of SWF’s in the United States. Both reports responded to questions that members of the Senate Committee on Banking, Housing and Urban Affairs had raised about the increasing investment activities of SWF's. The May report examines U.S. laws that specifically affect foreign investment and the processes that U.S. agencies use to enforce these laws. The report found that no laws targeted only SWF’s. It’s a important resource for any advisor or principal looking for a survey of the regulation of foreign investment. 

The Harvard Law School Forum on Corporate Governance and Financial Regulation contains a good summary of the report, authored by Jeff Trinklein, in particular that part of the report that catalogues the applicable laws:

Before proposing a transaction involving a U.S. asset, the GAO suggests that foreign investors should be aware of four different areas of focus.

1. CFIUS Review. The Foreign Investment and National Security Act of 2007, an amendment of the Defense Production Act of 1950, provides that any foreign acquisition, merger, or takeover of a U.S. business is subject to a review by the Committee on Foreign Investment in the United States (CFIUS), if the proposed transaction could potentially impair U.S. national security interests. The review is intended to determine if the proposed investment presents serious national security concerns, and if so, CFIUS can enter into an agreement that will impose conditions in order to mitigate those concerns. Following the review, the President is authorized to suspend or prohibit the transaction if there is credible evidence of a national security threat. Furthermore, due to recent changes in CFIUS rules, the normal 30 day review period is extended by an additional 45 days if state-owned entities are deemed to have a controlling interest in a transaction.

2. Emergency Powers. The International Emergency Economic Powers Act gives the President the authority to prohibit certain transactions if the transaction is seen as a threat to national security, foreign policy, or the economy of the United States.

3. Political Risk. General political risk may threaten a proposed investment. For example, the Dubai Ports World investment in U.S. port facilities was first approved by CFIUS but ultimately was abandoned due to the intense political controversy it provoked on Capitol Hill.

4. Public Disclosure. Any company that does business in the United States is subject to general reporting requirements including, but not limited to, confidential disclosure requirements for foreign-owned companies.

The report concludes that staff at certain agencies do not routinely review information from other governmental agencies or private sources to supplement the information that they use to enforce their own rules. GAO reached this conclusion after detailing the various and differing approaches to enforcement that six agencies follow. 

Reading between the lines, there may be a suggestion for a more uniform approach across federal agencies to foreign investment by SWF’s or perhaps even regulation centralized within a single agency.   There's no indication of whether there will be a third report and, if so, whether with wil address itself to the question of whether inter-agency uniformity or centralization would assist foreign investors who may be deterred by the current mutli-facted process.

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As of yesterday evening, the U.S. Supreme Court allowed the purchase of Chrysler’s business to proceed as part of Chrysler’s Chapter 11 proceedings. The sale now has closed. A consortium that includes Italy’s Fiat SpA will acquire key assets of Chrysler’s international operations, including the core U.S. business, within a matter of days. The deal has been prominent in the news, particularly when the appeal by pension funds and consumer groups generated some uncertainty. The deal also is historic because of the extent of the U.S. government’s direct involvement as a party and as a dealmaker.

The sale of Chrysler provides a case study for applying the Foreign Investment and National Security Act of 2007 (FINSA) and its implementing regulations, administered by the Committee on Foreign Investment in the United States (CFIUS). 

Fiat and its wholly-owned subsidiary--the buyer that will carry on Chrysler’s business--have entered into a “Master Transaction Agreement” with Chrysler and most of its subsidiaries. The U.S. Treasury, the Canada Development Investment Corporation and an independent health care trust have entered into agreements to subscribe for equity membership interests and become Class A members of the buyer. The buyer will apply the proceeds of those subscriptions to pay its $2 billion cash acquisition price to Chrysler. Fiat has agreed to contribute to the buyer certain rights to Fiat technology--including product platforms, powertrains and other key technology, management services, access to international markets and other distribution enhancements--and retains a 20% membership interest. The buyer can increase its 20% interest to 35% in three tranches of 5% each by satisfying certain performance metrics. Fiat also has the option to own a 51% membership interest in the buyer. Fiat and the buyer will be cooperating in the development of joint purchasing programs, the sale of Fiat products in North America and the sale of the buyers products elsewhere through Fiat’s network, R&D activities and branding opportunities. 

According to the White House’s initial announcement of the deal on April 30

• The U.S. Treasury will receive 8% of the equity of the new Chrysler and also has the right to select the initial group of four independent directors of the buyer; and
• The Canadian participant will receive 2% of the buyer’s equity of the buyer and will have the right to select one independent director on the same basis as the four independent directors initially chosen by the U.S.

Analyzing these parties and their relationship to each other under the U.S regime for regulating foreign investment leads to a conclusion that their deal is a “covered transaction.” Covered transactions are subject to the voluntary notice procedures that CFIUS administers and to unilateral CFIUS review if no filing has been made. If a deal is a “transaction” with “foreign person,” and if as a result the foreign person acquires “control” or could acquire “control” of a U.S. business, then the transaction is a covered transaction. The FINSA regulations give the words in quotation marks special meanings. Applying those special meanings to the facts of the deal determines whether the voluntary filing requirement apples. 

• First, since the transaction among Chrysler and the other parties is an acquisition, it is a “transaction.”
• Second because Chrysler is a business entity engaged in U.S. interstate commerce, it is a “U.S. business.”
• Third, is the buyer a “foreign person”? Under the rules, a “foreign person” is any entity over which a foreign person exercises control. Fiat is a foreign person. Before the deal it owns 100% of the buyer. After the deal it owns 20% of the buyer with the right to own 51%. The rules define control to mean the power to “determine, direct or decide important matters affecting an entity.” The basis for the right need not be a majority position; a “dominant minority” is sufficient. Fiat’s business arrangements with the buyer, the board members it presumably will be able to appoint and its ability to achieve 51% ownership satisfy the requirements for control to exist.  The public's perception, expressed by Carcorner, is that Fiat is in control.
• Fourth, the buyer--a foreign person--is conclusively acquiring control of Chrysler.

If the parties have entered into a covered transaction, have they filed with CFIUS? Although their agreement details what antitrust filings the parties will make, it uses general, non-specific language for all other governmental filings. The receipt of governmental approvals was a condition to closing for all parties. Was the condition met or was it waived to close ASAP? The details of what filings were being made are in annexes to the agreement that do not appear to be publicly available. 

It may be interesting to speculate here. In all likelihood, the parties have made their CFIUS filing. If Chrysler and Fiat have not filed, however, it may be because they perceive no national security aspect to their deal and therefore no risk that, because of the absence of a filing, CFIUS will challenge their deal--a risk that few others might take. In its December 2008 Annual Report, CFIUS provided data on filed transactions in the transportation segment of the manufacturing sector. This means that other parties in the industry concluded that there was sufficient connection between the segment and U.S. national security to justify the time, expense and delay of filing a notice with CFIUS. The Report also points out that CFIUS monitors surface transportation and industrial automation as “critical technologies.” 

Since all CFIUS filings are shielded from public access, until CFIUS issues its next annual report the public may not know whether Fiat and Chrysler filed. If they haven’t, could CFIUS challenge the deal when a different administration is elected? 

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The 2008 crisis in financial markets has led to increased government control and nationalization, of many financial institutions, including those based in the UK, Ireland and Europe. The financial institutions affected by these changes include banks that lend to U.S. businesses, directly or through subsidiaries. Among the results of partial or full nationalizations of those lenders could be greater regulation by the Committee on Foreign Investment in the United States, or CFIUS, the watchdog agency that monitors foreign direct investment into the United States. Along with increased regulation may come the unintended consequence that those foreign lenders that have become subject to increased government ownership and control may encounter restrictions or difficulty in enforcing their rights against U.S. borrowers. 

CFIUS administers the Foreign Investment and National Security Act of 2007, or FINSA. In November 2008, CFIUS published its final regulations, including rules that apply to non-U.S. lenders. The purpose of FINSA was to require approval for certain acquisitions and investments by foreign investors – those that could impair U.S. national security. The statute placed certain classes of transactions under a higher level of scrutiny by subjecting them not only to a first level of review by CFIUS but to a second level of investigation, unless CFIUS determines the investigation not to be necessary. One class of transaction requiring the enhanced investigation are those that could result in control of a U.S. business being held by

• a foreign government, or
• an entity that is controlled by a foreign government or that acts on behalf of a foreign government. 

When CFIUS wrote its regulations, it intended to include sovereign wealth funds because of the influence they were projected to have in the international economy. CFIUS may not have intended to include banks that were brought under the control of a foreign government as a result of major interventions as a result of an international fiscal crisis.

Transactions between foreign lenders and U.S. borrowers, whether secured or unsecured, are subject to a bifurcated regulatory approach: 

• Generally, there is no regulatory involvement when the parties enter into a conventional loan agreement; but 
• The regulatory scrutiny moves into place if and when the loan enters default or is about to enter default, since CFIUS considers the foreign lender’s enforcement of its rights to be a “covered transaction,” or a “takeover” of the U.S. borrower. 

Under FINSA, parties to a covered transaction may opt to file an extensively detailed notice with CFIUS. Failure to file the voluntary notice empowers FINSA, if it determines that the change in control will impair the U.S. national security, to block the covered transaction or to unwind it at a later time. For a negotiated merger or acquisitions deal, the risks of being blocked or unwound, if national security is involved, are generally of sufficient severity to transform the voluntary filing into a compulsory filing.

CFIUS does not report its determinations. As a result, it’s difficult to know with any precision what transactions with what U.S. businesses have raised U.S. national security considerations. A review of the last report that CFIUS made available to the public shows that parties to transactions with U.S. businesses in the following business segments filed notices:

• information technology
• telecommunications
• transportation equipment and services
• electric power generation, transmissions and distribution

In December 2008, CFIUS published its Guidance to describe what it believes are those parties whose involvement in covered transactions may raise national security implications. The Guidance also clarifies that the nationality of the foreign buyer and its nexus to the government of its domicile is important. CFIUS also takes into account the conformity of certain policies of the domicile’s government with critical U.S. policies, such as nuclear deterrence. It would not be much of an exaggeration to say that the acquisition of a retail outlet in a strip mall in foreclosure by a North Korean lender would, under the terms of its Guidance, trigger CFIUS review. The conclusion is that, for assessing national security risks, who the lender is matters as much as what the business of the target is.

To be fair, the CFIUS regulations attempt to provide some relief to foreign lenders. If a lender engages U.S. persons to manage the U.S. borrower of the foreclosure, CFIUS must consider that fact in making its determination. If foreign lenders are part of a syndicate controlled by U.S. lenders, and do not control the syndicate, the enforcement or foreclosure is exempt from CFIUS review. But if a lender is not able to comply with these narrow requirements, the foreign lender is left to deal with the CFIUS filing requirement. Since the borrower’s cooperation is required, the lender may well find itself in a surprising situation of asymmetrical power held by the U.S. borrower. For more detailed discussion of this unusual and anticipated outcome, subscribers are encouraged to read our white paper Treatment of Loan Transactions by Foreign Lenders as Regulated Foreign Direct Investments posted on the Sullivan & Worcester LLP Web site.

Foreign lenders now operating under the control or ownership of their governments face a broad array of challenges. The prospect of operating under a U.S. bureaucracy that examines their business dealings with defaulted borrowers is, no doubt, an unintended consequence. It may even be an unintended consequence of little consequence to the bank. To recover from the downturn of the past 18 months, however, the U. S. credit market, however, requires every bit of lender participation it can muster. To have any bank lenders step out of the market—particularly the market for mid-size and small businesses—would retard the recovery just as it seems to be gaining traction. The Obama Administration has spent months of efforts and billions of taxpayer dollars in coaxing the economy into recovery. CFIUS, being part of the Administration, might do to step forward and advise the community of foreign lenders the role it intends to play with regard to loan defaults by U.S. borrowers that result in foreclosures and other enforcement proceedings. 

The illustration above is courtesy of Joseph Rank. 

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